Monday, December 31, 2012

Kurt Schuler, on the blog Free Banking, linked to a paper by Shaikh on alternative microfoundations for macroeconomics and to a book by Belwy, Why Wages Don't Fall During Recessions.While the Shaikh paper was interesting, I found it too ideological, though paradoxically in its constant refrain that neo-classical economics is ideologically aimed at defending capitalism.

Belwy's work involved interviewing businessmen about why they don't cut wages and instead lay off workers during recession. He found that managers believe paycuts reduce morale and so productivity. When workers are laid off, "the misery is out the door."

Consider the following framing of the problem. We start at full employment, with firms hiring all the workers that want jobs. Spending on output falls, so firms cut back production and lay off workers. Some of the formerly employed workers are now unemployed.

When spending on output recovers, then firms expand production and rehire the laid off workers. As the unemployed workers return to work, the unemployment rate falls until workers are again fully employed.

Why is it that firms respond to the decrease in spending on output by reducting production and laying off workers? Why don't they instead cut prices and wages enough so that the lower amount of spending on output will buy the same amount of output, requiring the same amount of employment? Why not cut wages rather than lay off workers?

A brief look at the statistics regarding layoffs, quits, and hires suggests that this framing is wrongheaded. Even when there is no "recession," and unemployment is low, there are many layoffs. The number of quits is higher still. And new hires are greater than layoffs and quits, resulting in growing employment. The labor force is also growing, so unemployment remains stable and low.

Why do firms lay off workers when there is full employment? Surely it is due to conditions peculiar to their firm or industry. The market process of creative destruction involves decreases in the demands for particular products and so the amount of labor it is sensible for particular firms to use. At the same time, creative destruction creates new job opportunities with firms and industries that are expanding.

While firms could cut the wages of all of their workers, or solely the wages of those they would otherwise lay off, it is not at all obvious that this is sensible or desirable. Cutting wages enough so that part of the workforce quits and finds jobs in expanding sectors of the economy is hardly rational for a firm wanting to keep its most productive workers. Perhaps their industry will be one that expands in a few years, or even if not, that doesn't mean that their particular firm might not introduce a new product or production process and be able to expand market share and profits.

On the other hand, simply cutting the wages of the workers who would otherwise be laid off is less of a problem. If they quit, the result is no different than if they are laid off. Rather than a "pink slip," they get the pay cut, and that tells them that they better find a new job.

Managers apparently believe that it is better to "get the misery out the door."

Why is there a spike in layoffs during a recession? Why don't firms cut wages in a situation where their workers have no good alternative opportunities? Why do they instead lay off their workers?

This is the question upon which Belwy focuses, which is the natural one to emphasize given the naive framing--reduced demand for output, workers are laid off and become unemployed, and then, when the economy recovers, they are hired back.

However, the more relevant question is why don't firms cut wages (or slow the growth of wages) enough to continue the level of new hires?

Even with no spike, the ordinary level of layoffs will result in a rapid decrease in employment unless offset by new hires. Further, while quits drop during a recession, they don't fall to zero. Unless there are sufficient new hires, these quits result in lower employment. The new entrants to the labor force, both those who would be replacing some of who exit as well as the net growth in the labor force, will cause a rapid build up in the ranks of the unemployed.

Why do firms fail to cut wages, or even continue with previous rates of wage increases, while cutting back new hires? Why do firms not only fail to expand their work force as usual, but allow it to shrink through attrition?

By the end of the Great Moderation, employment had reached approximately 110 million and there were approximately 7 million unemployed, but that was despite there being approximately 22 million layoffs each year. Quits were even higher, nearly 34 million a year. That adds up to 56 million separations per year. Of course, new hires were running about 4.8 million a month, or about 58 million per year. The 2 million difference allowed for growing total employment.

If new hires fell to zero, and the quit rate remained the same, then within a year, employment would fall in half. Of course, quits fell off tremendously during the recession, to more like 20 million per year. But with this lower level of quits and "normal" layoffs, separations would still be 42 million. Without new hires, Great Depression levels of unemployment would rapidly develop in less than a year.

Of course, new hires didn't drop to zero. Even at the lowest, new hires were at an annual rate of 43 million. But the 15 million drop (per year) in new hires is the real problem that needs to be explained.

Sure, there were several months of very high layoffs . Three months of 2.5 million layoffs adds up 7.5 million unemployed--a significant number and roughly consistent with the increase in the number of unemployed.

Still, this was only 700,000 more layoffs per month than usual, and so that adds up to 2.1 million "extra" unemployed.

During that same period, new hires were approximately 1.2 million lower than "normal," which adds up to 3.6 million fewer jobs.

More importantly, after the "recovery" began, layoffs have been relatively low. The real problem is four years of new hires being about one million "too low" each month. It is getting to be close to 50 million "too few" jobs being created. (Of course, if new jobs had been created at that rate, most of them would be filled by people who quit their old jobs. Quits remain "too low" as well.)

Again, the real question isn't why firms layoff workers during a recession rather than cut wages. It is rather why firms don't cut their workers' wages enough so that they can keep new hires at a level consistent with full employment.

That pay cuts (or no pay increases) would hurt morale remains a plausible explanation. It is the focus on layoffs that is wrongheaded.

The right question to ask managers is why they don't give their current workers smaller raises, hire more workers (increasing starting pay less,) expand production more rapidly, and hold back on price increases to sell the extra output, and make more profit?

Sunday, December 30, 2012

If monetary policy is narrowly aimed at keeping nominal GDP on target, a reason for fiscal policy would be to prevent undesirable changes in interest rates. In particular, if deleveraging leads to a lower natural interest rate, then a budget deficit financed with T-bills would keep T-bill yields from falling. The decrease in national savings would dampen the decrease in the natural interest rate.

To show this, I described an alternative monetary regime that included no hand-to-hand currency. All payments are made with checkable deposits. The only form of base money is reserve balances-- deposits as well. Both checkable deposits and reserve balances pay interest. The interest rates paid on both reserve balances and checkable deposits change with the yields on earning assets. In particular, the interest rate the monetary authority pays on reserve balances changes with the yield on Treasury bills. The monetary authority uses ordinary open market operations to target a growth path for nominal GDP.

Consider a modification of the monetary regime. The banks can issue hand-to-hand currency on the same terms as checkable deposits. Base money still takes the form of reserve balances, but there is zero-interest hand-to-hand currency. If a bank wants to issue currency, and its depositors want it, they can withdraw it from their banks. If retailers want to accept it, they can and then deposit it along with the paper checks they receive in their own banks. The monetary authority accepts currency, along with paper checks, for deposit in reserve accounts. The monetary authority then clears the currency by debiting the reserve balances of the banks against which the currency was drawn.

Under "normal" circumstances, issuing currency is attractive to banks. A bank can hold earning assets funded by borrowing at a zero nominal interest rate.

However, if massive deleveraging pushes the natural interest rate low enough, issuing currency can become unprofitable. As a rough rule of thumb, if interest rates are so low that competitive interest rates on checkable deposits are negative, then issuing hand-to-hand currency at a zero interest rate would be unattractive to banks.

Suppose that banks cease issuing currency when it becomes unprofitable. While households who would have withdrawn and spent currency cannot do so, they will have more funds left to spend by writing checks. While those firms that specialize in making sales for currency, would be harmed, other firms will reap increased sales. There is no particular reason to believe that stopping the issue of currency would impact nominal GDP.

Of course, the disruption of the business of firms specializing in currency sales is undesirable. (On the other hand, with black market activity and tax evasion, it isn't clear that the monetary authority would be too worried about this disruption.) What is the answer? Fiscal Policy.
If the government runs a budget deficit and decreases national saving, it raises the natural interest rate. By increasing the natural interest rate, it can make the issue of hand-to-hand currency profitable for the banks, ending the disruption of the business of firms specializing in currency sales.

So, there is a rationale for fiscal policy. The government needs to run deficits to make the issue of hand-to-hand currency profitable. (Or perhaps less costly.)

In conventional monetary regimes, where the monetary authority issues hand-to-hand currency, it has a powerful incentive to request the aid of the "fiscal authority" to avoid issuing hand-to-hand currency when the expected yield on earning assets is extremely low.

When the monetary authority purchases long term or risky assets (what is sometimes treated as essential to "quantitative easing,") it is taking on risk not justified by the yield on the assets. Unfortuantely, a monetary authority can frame the problem in a different way. It can take it's obligation to issue hand-to-hand currency as an absolute, and then plead an inability to keep nominal GDP on target. Given this framing, it would claim it needs the help of the fiscal authority to maintain aggregate demand. But really, the problem is that it is unprofitable to issue hand-to-hand currency.

Generally, a take a "Virginia School" approach to public finance. I think that "fiscal policy" should be aimed at the appropriate provision of public goods. Voters should have a good idea of the taxes they must pay, signaling the private goods that must be sacrificed to produce the public goods. Each voter can then consider the benefit of the public goods to be produced versus the private good that must be sacrificed.

However, "fiscal policy" could be used to manipulate interest rates.

To see this, consider an alternative monetary regime. It has no hand-to-hand currency, with all payments made by checkable deposit. Base money is also solely made up of deposit accounts, which banks use to clear checks.

Banking is competitive, so those holding money earn interest on their deposit accounts. The monetary authority also pays interest on the deposits that serve as reserve balances.

Monetary policy occurs through open market operations with Treasury bills. The monetary authority pays an interest rate on reserve balances less than it earns on the Treasury bills it holds as earning assets. The monetary authority's target is a growth path for nominal GDP.

After households and firms reflect a bit on the old saying, "neither a borrower or lender be," a massive deleveraging occurs. Not only do firms refrain from selling new debt to finance capital goods, they use current revenues to pay down debt rather than buy capital goods. At the same time, households refrain from obtaining new consumer loans and use current income to pay down existing consumer debt.

The decrease in spending on capital goods by firms and decrease in spending on consumer goods by households would tend to push nominal GDP below target. Another way to describe the situation is that investment demand decreases and saving supply increases. The natural interest rate is lower. If market interest rates adjust with the natural interest rate, the quantity of saving supplied and quantity of investment demanded will adjust enough to prevent or reverse the decease in spending on output, so that nominal GDP would either remain on target or promptly return to target.

How might interest rates adjust?

As households and firms pay down debt and refrain from obtaining new loans, a single bank would have excess funds to lend. This would be reinforced because as a bank's deposit customers receive net repayment of loans, they would be depositing more funds.

Any individual bank can accumulate reserve balances with the monetary authority. But since the interest rate paid on those balances is lower than what can be earned on T-bills, purchasing T-bills would be a more profitable use of funds.. Meanwhile, any households or firm receiving net loan repayments could simply hold money--balances in a checkable deposit--but purchasing T-bills is likely to be a better option for them as well. And so, consideration of the impact of the deleveraging suggests that Treasury bill yields would be driven down.

Now, if we assume for a moment that the monetary authority keeps the interest rate it pays on reserve balances unchanged, then these lower T-bill yields reduces the opportunity cost of holding reserve balances, so that the demand for reserve balances rise. Banks would be motivated to accumulate "excess" reserves. (This monetary regime has no reserve requirements.)

Similarly, if we assume for a moment that banks keep the interest rates paid on checkable deposits unchanged, then the lower T-bill yields reduces the opportunity cost of holding money. This would result in an increase in the demand to hold money.

If all banks seek to accumulate reserves, the actual impact is a decrease in the quantity of checkable deposits--the quantity of money under this regime. And if people choose to hold more funds in checkable deposits, this is an increase in the demand to hold money. The resulting shortage of money would cause a decrease in spending on output, pushing nominal GDP below target.

However, with this regime, the monetary authority drops the interest rate it pays on reserve balances in proportion to the decrease in T-bill yields. Assuming banks hold T-bills, the lower interest received on their earning assets would cause them to lower the interest rates they are willing to pay on checkable deposits as well. Considering the scenario more broadly, the reduced credit demand faced by banks would lead them to lower all of the interest rates they charge for loans, and the resulting industry-wide decrease in the interest rates received on earning assets would lead competitive banks to lower the interest rates they pay on checkable deposits as well.

By simply removing the assumption that the monetary authority keeps the interest rate paid on reserve balances fixed (perhaps at zero) and the interest rates banks pay on deposits is fixed as well, the impact of the deleveraging has no obvious effect on either the quantity of money or the demand to hold money. From a monetary disequilibrium perspective, there is no tendency for spending on output to fall. Nominal GDP should remain on target.

From a Wicksellian framing, the lower interest rates, including the ones that banks charge and pay, decrease the quantity of saving supplied and increase the quantity of investment demanded. This is an increase in spending on consumer good and an increase in spending on capital goods, so that total spending on output remains unchanged and nominal GDP remains on target.

It is certainly possible that interest rates on checkable deposits, Treasury bills, and assorted bank loans would remain above zero. However, it is also possible that some or all of these nominal interest rates would fall below zero.

Consider the following scenario: checkable deposits have a negative interest rate--people holding money must pay to hold those balances. The interest rate the monetary authority pays on reserve balances is also below zero. Banks pay to hold funds in reserve balances. The interest rate on T-bills is below zero. People holding T-bills pay to lend to the government. The government borrows at a negative interest rate. However, the interest rates banks charge for loans remain slightly above zero.

The negative interest rate on checkable deposits deters those receiving net repayment of loans from simply holding increased money balances. They receive a signal and are given incentive to reduce their saving, or dissave out of accumulated wealth, spending on consumer goods. Presumably, purchases of consumer durables would be sensible. Similarly, firms that are earning profits would be deterred from accumulating revenues (and profit) in the form of checkable deposits and instead spend on capital goods.

Returning to the scenario of deleveraging, it is true that some of those who wanted to pay down debt may reverse, or at least postpone, their efforts. And some of those who were refraining from borrowing might respond to the lower interest rates by borrowing more. In aggregate, the deleveraging might stop, or at least be dampened and slow down.

Suppose that retirees had saved during their working years planning to spend their asset income and gradually dissave to fund consumption later in life. While they may have accumulated stocks and long term bonds during their working years, when they retired, they sold those off and instead purchased T-bills and various types of bank deposits. They wanted to avoid risk of capital loss when they dissave by selling off securities. Now that they are retired, they spend all of the income they earn on their T-bills and bank deposits. As the T-bills and bank deposits mature, they only reinvest part of the funds and consume the rest.

The massive deleveraging reduces their interest income to below zero and requires that these retirees dissave more than planned. The most likely scenario is that their consumption falls now and is expected fall by more in the future. The least bad solution of an individual would be to purchase longer term bonds to obtain more yield. Of course, with the plan to gradually dissave, this results in risk of capital loss. A market solution would be to purchase an annuity. The insurance company can then bear the interest rate risk directly.

But there is an alternative. Fiscal policy!

The government can cut taxes and instead fund government expenditure by the sale of T-bills. Or, it could introduce new spending programs and fund them by the sale of T-bills. Or, it could do both.

The retirees are earning "too little" on their T-bills, so the solution is for the government to sell more, increasing the yield. The retirees are earning "too little" on their short term borrowing, so the solution is for the government to borrow more.

Framing this in terms of saving supply and investment demand, when the government runs a budget deficit, this is a decrease in national saving, which raises the natural interest rate. An increase in the natural interest rate increases interest income for creditors. If the level of interest rates needed to coordinate saving and investment is considered "too low" for any reason, the government can intervene by running deficits and reducing national saving.

My own view is that the proper level of interest rates is the one that coordinates saving and investment, and so, I would oppose using "fiscal policy" to manipulate interest rates. Still, consider a monetary authority that frames its activity in terms of manipulating interest rates. Would such a central bank be inclined to insist that it needs the aid of fiscal policy to keep spending on target when really what it needs is fiscal policy to change the interest rate where saving equals investment to what it considers an acceptable level?

Saturday, December 29, 2012

David Andolfatto has an interesting post suggesting that a Taylor rule would could generate a "bad" low inflation equilibrium where the nominal interest rate is zero and real output remains below potential. (HT to Mark Thoma.) Targeting the quantity of money avoids this problem. (Or my understanding is that it is only when the quantity of money is allowed to adjust with the demand to hold it, and only interest rates are targeted, that this bad equilibrium was possible.)

Of course, Andolfatto's discussion is in terms of a pretty arcane model, where everyone saves all their income when young and the only choice is whether to buy government bonds or capital goods to fund consumption when old. His definition of potential output is based upon some efficient capital stock and the natural interest rate is the marginal product of that capital. Output is below potential when people buy too many bonds and not enough capital and so less output is produced. To me, output is always equal to potential in this model and potential output is just lower when the capital stock is lower. Further, I don't think the natural interest rate is the marginal physical product of some optimal amount of capital.

Suppose that people can invest in gold or else capital goods. If gold is expected to appreciate more quickly, then people shift to gold and out of capital. The capital stock is lower and presumably the marginal product of "capital" is higher. The least productive uses of capital goods are sacrificed, and those that are remaining are somewhat more productive. Also, because there is a smaller capital stock, productive capacity is a bit lower. What happens to the resources that are not used to produce the capital goods? They are used to produce consumer goods enjoyed by those who earned capital gains on their existing gold holdings.

Now, suppose that there is a gold standard. A lower inflation rate is gold depreciating less rapidly, and when it shifts over to deflation, it is gold appreciating more rapidly. If people choose to hold more gold and less capital goods because there is a higher deflation rate, then potential output is a bit lower than otherwise and the marginal product of capital a bit higher.

I think this is the effect that Andolfatto is capturing in his model. If this is an issue, one answer is an inside money where real money balances are invested in capital goods. Of course, even in that scenario, people can still save by accumulating stocks of commodities. In my view, trying to ban that to increase investment in production processes is a bit draconian.

Andolfatto's model is in terms of bonds, though he does mention that bonds can be interpreted as interest bearing money. (Good, keep up with that. Most money does bear interest. Don't fall into the trap of identifying money with noninterest bearing hand-to-hand currency.) Can government debt play the role of gold?

Everyone wants to hold government bonds. The nominal interest rate is driven to zero. Inflation slows and perhaps turns to deflation. This makes holding government bonds even more attractive. More wealth is held in the form of government bonds, and less in capital goods. Potential income falls and the natural interest rate rises.

One solution to this problem would be for the government to sell additional bonds to fund the purchase of capital goods. If there are some capital goods (road and bridge repair) that it is sensible for government to purchase, that would seem desirable. Otherwise, it appears that lower real interest rates on government bonds would result in more investment, capital, and potential output. This could be generated by a higher inflation rate or else a negative nominal interest rate on government bonds. With government issuing zero-interest rate currency, a negative nominal interest rate on government bonds is impossible.

In my view, an important part of our current problem is a failure of markets for short and safe (mostly government guaranteed) debt to clear properly. Negative nominal yields are necessary on some financial assets. In my view, the first best answer isn't a higher inflation rate, but rather getting government out of the business of issuing of hand-to-hand currency. If the nominal and real yields on "government bonds" can always adjust enough to clear, then households and firms will switch to funding capital goods.

Still, for the U.S. economy, it seems to me that these problems will show up as an increase in current consumption and a decrease in investment. Those already holding government bonds would earn real capital gains until they felt wealthy enough to expand their real consumption. However, investment and capital accumulation would be less, so productive capacity would shift to a lower growth path.

I don't think that the U.S. economy is in this situation. Real consumption has not recovered to the growth path of the Great Moderation. Still, I am pleased that Andolfatto is seeing some problems with this fixation on the "Friedman rule" of deflation equal to the negative of the real interest rate. Sure, it is great for those holding money to have a risk-free, perfectly liquid asset that pays the real equilibrium interest rate. But does it make sense to pay them any interest if they are not providing resources to fund real investment and expand the production of consumer goods in the future? Pay positive nominal interest rates on money, reflecting the actual risks (both in terms of failure of investment products and duration) for actual funding investment in capital goods.

Currency? Currency! Quit making the tail wag the dog. Yes, it is useful for a limited set of transactions. But don't make it the center of the economic universe and require everything else to accomodate it.

Thursday, December 27, 2012

Tim Duy argued that the real news about Japan was not just the commitment to raise the inflation target to 2% or 3%, but rather the commitment to combine fiscal and monetary policy. He went on to argue that Bernanke never claimed monetary policy can generate inflation alone, but only in combination with fiscal policy. The "helicopter drop" monetary policy would be a tax cut nominally funded by government borrowing, but with a parallel open market operation, it would be effectively funded by money creation. He quotes Bernanke as claiming that the Fed cannot offset the fiscal cliff. Duy claims that since the Bank of Japan cannot hit its 1% inflation target, simply promising a higher inflation target will be so much empty talk.

Japan already has a budget deficit of nearly 10% of GDP, but the only way an expansion of the quantity of money can have an impact is if it is matched an increase in that deficit? I don't think that makes sense.

I believe that a monetary regime can generate a 2 or 3% target inflation rate regardless of fiscal policy. Of course, if other constraints are added, such as the exchange rate can't fall too low, or nominal or real interest rates can't fall too low, or only certain assets can be purchased by the monetary authority, or some measure of the quantity of money can't be allowed to grow too fast or rise too high, then some inflation target may be completely unfeasible.

Like most Market Monetarists, I also think that growth rate nominal anchors are a bit harder to hit. If the Bank of Japan targeted a 1% growth path for the price level, rather than a 1% inflation rate, it would have more success. A central bank willing to forgive and forget its own errors receives less help from firms and households in achieving its goal.

But leaving aside other contradictory goals and the problems of growth rate targets, it is foolish to even start to claim monetary policy is inadequate before reserve balances have negative nominal interest rates matching the cost of storing currency, currency is only issued in denominations useful for small face-to-face transactions (rather than large denominations useful for saving,) and the monetary authority has purchased the entire national debt, including agency issues. If that has occurred, and the government is running budget deficits, then the monetary authority would be purchasing all of bonds issued, effectively funding them by money creation.

At this point, monetary policy would not be "ineffective." It is rather than some constraints have become binding. The monetary authority could still expand the quantity of base money by purchasing foreign government bonds or private securities--commercial paper or bonds and notes. The charges on holding base money could be increased, but further restrictions would need to be be placed on the withdrawal of hand-to-hand currency.

It is only in this context, when limits on the issue of hand-to-hand currency, the purchase of foreign bonds with exchange rate risk, and the purchase of previously off-limits assets are required because all of the others have been bought are on the table, should there be a fourth alternative put on the table-- a request to the politicians to borrow more (and lower taxes or spend the money.)

Again, it isn't that monetary policy is "ineffective," but rather that some existing constraint on monetary policy must be changed. In my view, purchasing private debt instruments, such as AAA commercial paper and corporate notes and bonds is just a no brainer. That should already be on the usual list of assets to be purchased, along with government bonds. In my view, the monetary authority should be diversified rather than operating as an effective branch of the Treasury and ignoring the risk of default by the "fiscal authority" (the politicians.)

But, if the situation arises where all high quantity private securities are purchased, and all the government debt is purchased, then the situation could arise where all that is left is the purchase of securities denominated in foreign currency, restricting the issue of hand-to-hand currency, or going to the government with a request that it borrow more.

Since I believe the monetary authority should get out of the hand-to-hand currency business anyway, there is never any need to request aid from the fiscal authority. Naturally, I would advocate restrictions on the issue of government currency before proposing that the government borrow more money for the purpose of stabilizing nominal expenditure on output.

If there is an excess demand for base money, the only issue is whether the yield on base money be reduced and so reduce the demand, or else assets be purchased to expand the quantity. If all of the appropriate assets have been purchased, then reducing the yield on base money is the only alternative. This might involve paying a lower positive nominal interest rate on base money, but if needed, it could involve negative interest rates--charges to hold base money. And there is no lower bound on that.

Wednesday, December 26, 2012

...to implement a target growth path for nominal GDP (or to target inflation or to manipulate the output gap.)

The problem is that fiscal policy involves changes in taxes and government spending. Politicians (and many economists) have strong views about the proper level and composition of government spending as well as the proper level and composition of taxes.

Given the quantity of base money or some target for interest rates, it is very likely that lower taxes with unchanged government spending will result in more spending on output. The demands for various private goods services will be higher than otherwise.

It is almost certain that with given taxes an increase in government spending will result in more spending on output--mostly limited to what the government itself purchases.

It is probably true that nearly all politicians have some taxes they would like to see cut and some government spending they would like to see increased. But there are also many politicians who are dead set against cutting some taxes. And there are politicians who are very much opposed to raising some types of government spending. In fact, there are politicians committed to raising some taxes and cutting some types of government spending.

For example, a typical conservative Republican might favor cutting the relatively high marginal tax rates facing those with high incomes. He might favor increases in defense spending. At the same time, he might favor cutting various sorts of social programs that purportedly help the poor and working class (well, that's what the Democrats say these programs do.) He might even accept the need to limit the growth of entitlement spending that benefits his own middle class constituents! In general, this conservative Republican doesn't want to see the burden of the Federal government grow, and maybe would like to see it shrink, at least relative to total size of the economy.

Meanwhile, the typical liberal Democrat might favor tax cuts targeted at the poor and middle class, but she is very much opposed to cutting taxes on higher income groups. On the contrary, her long term goal is to raise those tax rates. Shifting the tax burden toward the rich and away from the poor to equalize after tax income is a long term priority. Similarly, raising defense spending (unless it happens to be in her own district) is not a priority, because shifting the composition of spending towards programs that benefit the poor and middle class is a long term goal. (The Democrat activists who earn their incomes running the programs certainly claim they are helping the poor and working people.) In principle, this liberal Democrat would applaud an expansion in the size and scope of the Federal government to help provide for urgent social needs and solve severe social problems.

"Fiscal policy" can probably impact spending on output but proposals to cut taxes and raise government spending are going to shift tax shares, the composition of government spending, and the overall size and scope of the Federal government. These are highly controversial questions.

If one imagines that one faction has absolute political dominance, then it can cut the taxes it likes least and raise the spending it likes most. By focusing more on tax reductions or increases in government spending, it can move towards its preferred size and scope of government.

But with separation of powers and divided government, why should we expect that these other concerns will not overwhelm any interest in maintaining the level of spending on output, keeping inflation on target, or closing output gaps?

When liberal Democrats insist that we should cut the taxes that they always would like to see cut and spend on the government programs that they aways want to fund, saying that in addition to all of their usual reasons for these policies they are needed now to increase total spending, aggregate real output, and employment, why shouldn't we expect that their political opponents not only will respond with the arguments that they usually use against these policies, but to also add claims that these policies really won't improved economic conditions? Isn't it the opposition's obligation to refute these arguments?

More importantly, if the conservative Republican opponents control the House and can filibuster in the Senate, why wouldn't they block the proposals? Maybe they reasonably believe that whatever impact these policies might have on total spending on output are less important than their other adverse effects.

Similarly, when conservative Republicans propose permanent cuts in marginal tax rates and increased defense spending, why wouldn't we expect that these efforts would be blocked in the Democrat-controlled Senate or face a Presidential veto? Maybe whatever gains are generated in solving the aggregate spending problem (or closing the output gap) are just less important than long run efforts to shift the burden of taxation and the composition of government spending.

In my view, economists who see themselves close to the halls of power--whether truly as advisers in government or merely pundits, adopt the mentality of the politicians. They are all in favor of fiscal policy to solve a shortfall in spending, as long as the fiscal policies are ones that they would support anyway. Many appear quite willing to trot out doubtful arguments, expecting the opposition to refute them. (That monetary policy is out of ammunition so we must cut the taxes my "Team" has always wanted cut and increase the spending that my "Team" always wants to fund, is the most frustrating and heartbreaking to me.)

As for those economists way up in the ivory Tower, they simply abstract away from these real world complications. Should we use fiscal policy to help close an output gap? Sure, all the best models suggest it will help with the policy rate at zero. (And let me get back to working some equations.)

If they have little concern with short run stabilization policies, perhaps focusing on research programs that cast doubt on the effectiveness of such measures, whatever preferences they have about tax shares, the composition of government spending, or the proper size of government, may well shine through. Should we lower taxes? Sure, lower marginal tax rates improve the efficient allocation of resources. Should we cut government spending? Sure, most government spending is wasteful rent seeking. Should we raise defense spending? Sure, I am worried that Iran will use nuclear weapons on Israel. But why should we give the off-the-cuff opinions of some ivory-tower macroeconomist much credence?

In my view, a monetary regime should not require "cooperation" with the fiscal "authority." Creating "givens" for base money or targets for interest rates and then suggesting that the fiscal authority adjust taxes and spending to keep nominal spending (or the output gap and inflation) at the proper level is a mistake.

In my view, the monetary authority should have a single focus--keeping nominal GDP on a stable growth path and it needs the ability to do so regardless of fiscal policy. Whatever fiscal policy the politicians develop, it should occur in the context of slow, steady growth of nominal GDP.

Monday, December 24, 2012

Alex Salter has a working paper where he contrasts the Market Monetarist approach with Free Banking. Market Monetarists advocate a nominal GDP level target. Many advocates of free banking, following George Selgin, argue that free banking will tend to stabilize nominal GDP.

Salter argues that having a central bank adjust the quantity of base money to keep nominal GDP on a stable growth path is very different from allowing free banks to operate so that nominal GDP is stabilized. In my view, he exaggerates the differences. Further, I find the way he describes the difference disconcerting.

Salter argues:

The monetary disequilibrium theorists regard NGDP as an emergent phenomenon of the competitive market process as described by Mises (1949), Hayek (1948) and Kirzner (1973). It is not something that exists as an object of choice for any individual or group of individuals. Rather it is the unintended consequence of the decentralized actions of private bankers who, in attempting to maximize profits, offset changes in inside-money velocity with corresponding and opposite changes in the circulation of their privately-issued money. The end result is a state of affairs where nominal income is stabilized, meaning the impacts of changes in the supply and demand of bank-issued money are minimized, approximating the ideal of monetary neutrality.
In contrast, the view held by (some) Market Monetarists treats NGDP as an object of choice—or rather, something that ought to be treated as an object of choice, and one that ought to be acted upon in order to prevent the economy from deviating from its trend growth path. The view is inherently mechanistic: the economy proceeds smoothly along its growth path until it is disturbed by some sort of shock, in which case the monetary authority takes action to stabilize aggregate demand, meaning to stabilize NGDP. The motivation, as before, is an attempt to approximate monetary neutrality as closely as possible.

I think nominal GDP measures the nominal value of the goods and services produced over time. I think this is "an emergent phenomenon of the competitive market process." Firms quote prices and produce output aiming at profit. They make their decisions according to plans to sell products to households and other firms. The firms they plan to sell to plan to sell to households or still other firms. And when the prices times the quantities of all of this competitive market activity during some period of time are added up, it comes to a total. Once care is taken to avoid double-counting, the result is nominal GDP. The owners of the resources used to produce this output earn matching incomes. Sum up all of those incomes--the services provided times prices of the services, when combined with depreciation, also results in nominal GDP. How much of which resource is used by which firm and how much they are paid, including the profits plus depreciation of various firms, is also "an emergent phenomenon of the competitive market process."
The prices firms set and the quantities they produce very much depend on how much they expect to sell. Market Monetarists argue that the key role of the monetary regime is influencing expectations of what firms expect to be able to sell. This determines how much labor and other resources they will hire and what they will pay for them. The primary determinant of what consumer goods and services firms produce and what they charge is what households find most valuable. And the firms produce products for other firms similarly based upon what these other firms are willing pay, which in the end depends on what households value products.

In my view, the competitive market process is one of creative destruction, with firms constantly introducing new products and new processes that they believe will be more profitable. What the monetary regime does primarily is define the environment under which these products will be sold. Market monetarists believe that expectations of a slowly growing level of nominal GDP is the best environment. No firm can know how much buyers will spend on their product, but what they do know is that if less is spent on their product, more is spent on some other product.

Market Monetarists have come to understand that these expectations are very powerful and that what is most important is that the monetary regime be expected to support them. As long as the quantity of money is expected to be adjusted in a way consistent with slow steady growth in spending on output, then the actual quantity of money can vary substantially. The demand to hold money can passively adjust. However, when expectations change, and the monetary regime is believed to be aimed at some different goal, then disruption can be rapid. If the quantity of money is expected to adjust in ways such that it will persistently deviate from the demand to hold money at some particular level of nominal GDP, then expectations for nominal GDP will change quickly.

Anyway, I think it makes some difference whether the growth path of the quantity of base money is the nominal anchor or the growth path of spending on output is the nominal anchor. With the first, the path of base money is an object of choice and mechanistic, and nominal GDP develops according to changes in the demand for base money. With the second, the growth path of nominal GDP is an object of choice and mechanistic, but the quantity of base money depends on the demand for base money. The demand for base money is part of the competitive market process, but it very much depends on expectations.

Still, the primary practical difference between the two monetary regimes is going to be the expectations generated for nominal GDP. If some particular growth path of base money, combined with the activity of the profit maximizing banks, is expected to generate a similar level of nominal GDP to a central bank adjusting the quantity of base money, the final result will be very much the same. It is expectations of how demand will develop in the future that will have the largest effects on the spending in the present.

In particular, the notion that it is the decisions of particular banks about where they want to lend that determine the pattern of expenditure in the economy and so "nominal GDP" seems backwards. The pattern of credit demands, or more broadly, the demands for finance, and expectations about what particular products will be most profitable, seem much more important.

Further, Market Monetarists have been very critical of efforts by the Federal Reserve to direct credit. Paying interest on reserve balances and allocating its asset portfolio to correct market failures has no connection to the Market Monetarist approach. Most banking activity has been private, profit maximizing activity, and that is just fine with Market Monetarists.

Reserve requirements play no role in the Market Monetarist approach. As far as I know, no Market Monetarist supporst them. On the other hand, Sumner, in particular, is critical of private currency issue. He believes it involves the government giving away its seigniorage income and that competitive issue of currency is likely to be wasteful. (Perhaps banks would give away toasters to people who come make currency withdrawals.)

I favor full privatization of hand-to-hand currency. But, I doubt that in a world of persistent government budget deficits, having part of them financed by the issue of central bank currency really makes much difference to the allocation of resources. Still, I wish Salter would consider such a scenario. Fully-private currency and no reserve requirements. Banks are free to issue monetary liabilities and lend as they choose. But the private monetary liabilities are redeemable in central bank deposits, whose quantity adjusts so that expectations of nominal GDP are kept on a slow, steady growth path.

There is a price ceiling on gasoline, a bit above the previous equilibrium price. The market price rises to the ceiling and shortages develop.

The fears have been realized. It really is difficult to find gasoline. Whenever any appears, everyone tops off their tanks and fills up gas cans.

If the ceiling were removed, the shortages would disappear. We can imagine the price rising above the ceiling to clear the market. But then, once everyone knows that they can get gas when they want it, the hoarding dissipates, and the market price falls back to its initial level--below the ceiling.

Suppose some people never believe that gasoline was running out. Suppose some people knew that the shortages were caused by the ceiling.

But there were many people who believed the crazy rumours and never paid attention in economic class. It is all a bunch of graphs and numbers.

Just because someone knows that the reason for the shortages is a phantom and price controls doesn't mean that they do not benefit from hoarding gasoline too. They don't want to run out.

But these clever people know that if the ceiling is removed, the price of gas might rise for a time, but it will soon fall. If there are enough, perhaps they just stop joining the lines. Once they quit hoarding, there is no shortage at the ceiling price, and it beings to fall. The less clever people also notice that there is no shortage too and also that the price is falling. They quit hoarding as well.

Allowing the price to rise above the ceiling results in an immediately fall.

If no one believed that gas was going to run out, and believed that no one else believed that gas was going to run out, there would be no hoarding. The ceiling wouldn't matter.

If no one believed that gas was going to run out, but believed that everyone else believed that gas was going to run out, there would be hoarding. The ceiling would create a shortage. If we could just convince everyone that there was nothing to fear but fear itself, the problem would be solved. Or, if the price was allowed to adjust, the shortage would go away, and the prices would soon fall again.

If everyone believed that gas was going to run out and believed that everyone believed it too, then the hoarding occurs, prices rise, the ceiling is binding, and everyone sees that gasoline really is running out. Get rid of the ceiling, and their eyes will be opened.

If some people believe that gas is not going to run out and that the problem is the ceiling, but others do not, then it is possible that ending the ceiling will result in the shortages ending and prices falling.

The Taylor rule requires that the central bank lower its policy interest rate enough to close any output gap. If output is currently below potential, then this requires real output to grow more quickly. If this more rapid output growth is anticipated, then expectations real output growth will increase current real expenditure. This is a force that tends to increase "the" natural interest rate. This effect means that only a smaller decrease in the policy rate should be necessary to close the output gap.

An alternative framing is that expecations of more rapid growth in real output will tend to raise credit demands and put upward pressure on nominal market interest rates. While the money creation needed to expand nominal and real expenditures enough to close the output gap tends to put downward pressure on "the" nominal market interest rate, the net effect on "the" nominal market interest rate is smaller than otherwise.

Market Monetarists sometimes argue that it is possible that a commitment to open-ended quantitative easing tied to an explicit target for nominal GDP could result in increases in all market interest rates, a closing of the output gap, and no increase in inflation.

I have made this argument multiple times. Be mindful of the could. It is also possible, and perhaps more likely, that open-ended quantitative easing in service of a nominal GDP level target would result higher inflation and further some nominal interest rates might fall. Market Monetarists simply insist that higher inflation or lower nominal interest rates are not essential to the recovery process.

Is this really possible? The Fed is already committed to closing the output gap. If the reason nominal GDP is below some particular growth path is solely because of an output gap, then closing the output gap will bring nominal GDP up to that growth path.

If firms and households believe the Fed will lower the policy rate enough to close the output gap and this results in sufficient real spending now to require a higher policy rate to prevent real output from outstripping potential output, then there really shouldn't be an output gap at all, or at the very least, there should be a rapid recovery of output without any decrease in the policy rate.

The Market Monetarist argument appears to be that interest rates are low because real expenditures are expected to be low. If real expenditures are expected to be higher, then interest rates would be higher. How can we explore that possibility?

Consider an economy where market interest rates freely adjust with the natural interest rate. Unfortunately, in this economy, households and firms sometimes get the vapours. From time to time, the animal spirits are weak.

Households worried about depressed economic conditions in the future fear that if they lose their job, they will take a very long time to find another. They reduce consumption and save more. The supply of saving increases.

Firms worried about depressed economic conditions in the future reduce investment. They spend less on capital goods because they fear these capital goods would simply add to their excess capacity in the future.

The increase in the supply of saving and decrease in the demand for investment result in a lower natural interest rate. By assumption, the market interest rate freely drops with the natural interest rate.

The lower interest rate decreases the quantity of saving supplied and increases the quantity of investment demanded. This is the same thing as an increase in spending on consumer goods by households and an increase in spending on capital goods by firms. At a sufficiently low interest rate, saving and investment would again match.

It is possible that the net effect would be more saving. But any increase in saving would be matched by an increase in investment. In other words, any decrease in consumption by households worried about difficulty in finding jobs would offset by an increase in spending on capital goods by firms.

It is also possible that the net effect would be less investment. The firms are worried about excess capacity, but any decrease in investment would be matched by a decrease in saving. Again, in other words, any decrease in investment by firms is offset by an increase in consumption by households.

Finally, with both saving increasing and investment decreasing, it is quite possible that the net effect is that the lower interest rate would leave saving and investment unchanged. The composition of spending on output in these broad categories would not be affected at all.

Now, if market interest rates do freely adjust with the natural interest rates, so that real expenditure is maintained, once households and firms notice that finding jobs is not especially difficult, and excess capacity is not a general problem, then their wrong expectations would likely dissipate. The supply of saving would fall again, and the demand for investment would rise again. Even though the expectations were wrong, market prices--market interest rates--would have adjusted to coordinate these expectations, leaving spending on output matching productive capacity. These market prices would have adjusted to falsify the false expectations.

Now, suppose there is a central bank which believes that excessively low interest rates are undesirable. Perhaps it worries about the interest income of retirees. Or, perhaps it worries that these low interest rates caused by incorrect expectations will motivate firms to undertake projects that would not be profitable at the higher "correct" interest rates. The central bank might even worry that some might borrow at these low interest rates to purchase stocks or commodities. The prices of these stocks or commodities would be too high--higher than they would be at the "right" interest rates. And if that is not a speculative bubble, the appreciation of the assets might attract further purchases. If some borrow to fund those purchases, that would clearly be a credit-fueled bubble. And, of course, since banks borrow short and lend long (or at least somewhat longer,) if banks project currently low funding costs into the future, then they might suffer losses or failure when their funding costs rise but they are locked into lending at lower long term interest rates.

So, to prevent these consequences, the central bank takes action to keep market interest rates from falling. By contracting the quantity of money or even keeping it from rising to meet the demand to hold money, the central bank creates a liquidity effect so that market interest rates fail to decrease enough for saving to equal investment at a level of real income equal to productive capacity. Real expenditure is permitted to fall below productive capacity.

Rather than interest rates falling enough so that the households and firms fears are shown to be an illusion, the central bank's policy causes unemployment and househods have great difficulty finding new jobs. Firms, face substantial excess capacity, choose to invest less. Their expectations have been confirmed.

We can imagine that the central bank keeps the market interest rate at the "correct" level. If the market rates were consistent with the natural interest rate initially, then the increase in saving and decrease investment lead to reduced spending on output, and confirm the pessimistic expectations of households and firms.

But suppose instead that market interest rates fall some, towards the new natural interest rate, and the central bank only blocks them from falling "too far." If the central bank's policy changes, and it allows market interest rates to fall enough for real expenditures to recover, then expectations will turn, savings will fall, investment will rise, and the market and natural interest rates will both rise above the central bank's previous "floor." The market interest rate first falls towards the depressed natural interest rate, and then both the natural and market interest rates rise with more optimistic expectations.

If no one knows that an initially lower market interest rate will result in an economic recovery and so less saving and more investment, and then a higher market and natural interest rate, then this time path of interest rates appears necessary. The market interest rates must at first fall towards the lower natural interest rate and then later rise once the recovery in real expenditures result in a higher natural interest rate again.

On the other hand, if everyone knows that market interest rates will soon rise again and that any decease is only temporary, and further, everyone knows that everyone knows this, it would seem unnecessary for the central bank to end its block on lower interest rates. There should be no need for market interest rates to fall to demonstrate that real expenditures will be maintained. The current market interest rate is below the natural interest rate consistent with everyone expecting real expenditures to match productive capacity.

Yet suppose that everyone knows this, but no one believes that anyone else knows. Everyone believes that market interest rates must fall, so that everyone else will spend more, and that only once that happens, will everyone else see the light, and saving will fall and investment rise. As far as each person is concerned, the central bank's block on keeping interest rates from falling too low is keeping spending too low. Interestingly, if the block disappeared, everyone would immediately reduce saving and increase investment.

In this scenario, it would seem possible that a change in policy by the central bank to allow market interest rates to fall enough to generate a recovery in real expenditure, would paradoxically result in an immediate increase in the natural interest rate and the market interest rate--both rising back to their initial level, above the central bank's floor.

Finally, suppose that there is a mixture of expectations. Some know that saving and investment will readjust once the central bank ends its policy of keeping interest rates from falling too low. But they correctly believe that others don't know. However, once those others observe growing real expenditures, production, and employment, they will adjust their expectations and reduce saving and increase investment.

The central bank changes its policy. Those who realize that now that interest rates will be allowed to fall as much as necessary for real expenditure to recover, immediately reduce their saving and expand their investment. While their adjustment would not be sufficient to bring the natural interest rate and market interest rates back to the initial value, they could bring the natural rate back up past the central bank's artificial floor, pulling market interest rates up from that floor as well.

As real expenditures recover, those who had no idea that the central bank's floor was causing a problem respond to the improved economic conditions. How fast do they respond? Suppose that they don't simply expect the depressed past to continue but rather believe that while the depressed conditions could continue indefinitely, it is certainly possible for there to be a return to prosperity. From their perspective, recession and recovery are a bit of a mystery. With such a scenario, the adjustment in saving, investment, the natural and market interest rates could be rapid indeed.

Perhaps these scenarios are incorrect. However, rational expectations seems to limit us to considering situations where everyone knows and knows that everyone else knows. If we imagine solving for savings supply and investment demand functions, that depend on expectations of aggregate real expenditure, and the expectations of aggregate real expenditure is the level of real expenditure generated by the solution, then the "low" market interest rates needed to coordinate saving and investment with pessimistic expectations cannot exist.

With a more realistic scenario, where some people know, and they also know that many other people don't know, an expansionary monetary policy might well result in a rapid increase in all market interest rates, both nominal and real, without there being any increase in expected inflation.

Tuesday, December 18, 2012

Market Monetarists advocate sound money. We favor a monetary regime where the quantity of money adjusts with the demand to hold money, resulting in spending on output growing at a slow steady rate. We believe that such a monetary regime creates the least bad environment for microeconomic coordination. Yes, that is microeconomic coordination. It includes creative destruction, inter-temporal coordination and so on.

Unfortunately, too many advocates of the free market blindly accept the wrongheaded framing of the Federal Reserve itself. Monetary policy is identified with interest rates and lending. The discussion appears innocent of even the fundamentals of economic analysis.

The fundamental forces that determine the level of interest rates are saving and investment. If we assume these are constant and that the current interest rate coordinates them, then any "monetary policy" that involves changing interest rates must be distortionary.

However, saving and investment are not fixed and unchanging. In particular, worries about the future can easily lead to an increase in the supply of saving and decrease in the demand for investment. This requires a decrease in the interest rate to bring them back to equilibrium.

An increase in saving is a decrease in consumption--spending on consumer goods. A decrease in investment is a decrease in spending on capital goods. The direct effect of these decreases in spending is reduced sales, production, and employment. However, the lower interest rate decreases the quantity of saving supplied--it stimulates spending on consumer goods. And the lower interest rate stimulates spending on capital goods.

How low should interest rates go? Until saving and investment are equal. That means that any decrease in investment spending is offset by an increase in consumption spending. Or any decrease in consumption spending is offset by an increase in investment spending. It is even possible that investment and consumption spending would remain the same.

It is a travesty that supposed advocates of the free market are complaining that interest rates are too low and so are harming savers. Yes, it is true that if saving supply rises and investment demand falls, then saving is less attractive. That is how market prices work. If the supply of corn rises and the demand falls, then the price of corn falls, and growing corn is less remunerative.

What about "blowing up bubbles?" When interest rates are lower, the present value of future flows of income is higher. This tends to raise the fundamental values of financial assets like stocks and also capital goods, including single family homes. This is one of the ways in which lower interest rates cause a decrease in the quantity of saving supplied and increase in the quantity of investment demanded so that they return to equilibrium. This is a coordinating adjustment.

Now, it is possible that foolish momentum traders will project past price increases into the future, and pay too much for assets. It is even possible that clever traders will also buy such assets, planning to sell to a greater fool. However, this is not a reason to prevent interest rates from coordinating saving and investment. It is not a reason to keep asset prices from rising despite lower equilibrium interest rates.

To repeat, when saving rises and investment falls, the market process that prevents this from causing a decrease in spending is lower interest rates. Complaining about lower interest rates in such a circumstance is simply anti-market propaganda.

Thursday, December 13, 2012

On the bright side, the Fed is continuing with its policy of open-ended open market operations. Further it plans to include purchases of longer-term Treasuries as well as mortgage backed securities. This at least moderates the degree of centralized credit allocation that was emphasized last month.

Second the Fed is continuing with its outcome-based approach, committing to continue with a low target interest rate until labor market conditions improve conditional on price stability. It has now explained what those vague terms mean--unemployment no higher than 6.5% and inflation no higher than 2.5%.

Unfortunately, the asset purchase (money creation) program has a very vague end point--when the recovery strengthens. Consistent with its continued wrongheaded focus on interest rates, it is the target interest rate that will remain low until unemployment falls to 6.5% or inflation in the medium term rises above 2.5%.

Worse, the Fed insists that long run inflation expectations must remain 2 percent. If we imagine that inflation suddenly jumps to 2.2% in 2014, it is certainly possible that inflation can be expected to be 2% from then on. However, if inflation is currently 2% and people today expect a rapid recovery will be associated with slightly higher inflation--say 2.2% in 2014, then the only way they can expect inflation to be 2% over a longer time frame, say to 2017, would be for inflation to be below 2% some point after the recovery. Is this some kind of commitment to a boom-bust cycle?

I suppose that if inflation is expected to be below 2% in the near future, this approach allows inflation to be above 2 percent in the medium term, averaging to 2% in the long term. But where does that leave us when the medium term arrives and inflation is 2% (or more?) Still looks like an expectations of disinflation at some future time.

As far as I can tell, all the 2.5% inflation rate in the medium term does is to allow for transitory supply shocks. If, for example, trouble in the Persian gulf leads to higher oil prices and a higher CEP in 2013, but after the war is over, oil prices will drop again, and so the CEP will either drop or grow more moderately for a time, the inflation rate over a short time horizon would rise, without it rising over a longer horizon.

As far as I can tell, this formulation is not consistent with a return of the price level to its previous growth path. If the price level is below its growth path, catching up with it implies a more rapid inflation rate over all horizons (short of infinity?)

Of course, I think allowing for more "flexibility" in dealing with transitory supply shocks is a good thing. I would hate to see the Fed tighten monetary policy in the face of a war scare in the Persian Gulf, citing worries about inflation expectations becoming unarmored. I just don't see how this helps with recovery.

From a Market Monetarist perspective, the proper policy is to identify a target growth path for spending on output and then commit to set the quantity of base money at whatever level is necessary to reach it. Under current conditions the relevant commitment would be to increase base money however much is necessary--$5 trillion, $10 trillion, whatever. There should be no commitment regarding inflation, unemployment, or interest rates. In particular, there should be no threat to call off the increase in spending on output if inflation rises above 2.5%. That threat to call off the expansion of spending due to inflation reduces the motivation to spend on output now.

I think most Market Monetarists would consider the growth path of the Great Moderation to be an upper limit on what is appropriate. In 2007, 2008, or 2009, most of us would have advocated returning nominal GDP to its previous growth path. On the other hand, after four years, Sumner is proposing two years of 7 percent growth and then 5% in the future. I favor a year of 10% nominal growth and then 3% in the future.

Anyway, it is conceivable that nominal GDP would reach the growth path of the Great Moderation, and inflation would be less than 2.5% and the unemployment rate above 6.5%. If that were to occur, the Fed's policy would be too inflationary from a Market Monetarist perspective. However, a more realistic expectation is that inflation will rise above 2.5% or else unemployment will fall below 6.5% before spending on output grows that amount.

I find the Fed's approach to shout "inflation-unemployment trade off." If our effort to push down unemployment results excessively high inflation, then we will call it off. But 2.5 percent inflation is acceptable if it causes a reduction in the excessively high unemployment rate.

The correct framing is that if real output is below potential, then the unemployment rate is above the natural unemployment rate. More rapid growth in spending on output should result in growing sales, production, and employment. This will raise output closer to potential and lower the unemployment rate closer to the natural unemployment rate. Unfortunately, it might also cause more inflation. If it does cause more inflation, we will put up with no more than 1/2 of a percent more inflation. Further once output and employment grow enough so that the unemployment rate falls to 6.5 percent, no more than 1 percent beyond the natural unemployment rate, then we will put up with no extra inflation from added spending growth that might bring output even closer to potential and the unemployment rate even closer to the natural unemployment rate.

If it turns out than real output is at (or close to) potential, so the unemployment rate is approximately equal to the natural unemployment rate, then to the degree more rapid growth in spending on output causes real output and employment to grow, it will push output beyond potential and push the unemployment rate below the natural unemployment rate. These changes in output and employment are likely to be transitory and the result will almost certainly be higher inflation. We will cut this program off as soon as it leads to 1/2 of a percent more inflation.

The Market Monetary approach is that the policy should be to get spending on output to target. If output is below potential and the unemployment rate is above the natural unemployment rate, then growing sales, production and employment should bring output closer to potential and the unemployment rate closer to the natural unemployment rate. That is good. It would likely be associated with higher inflation for a time, though once the target growth path is reached, the inflation rate will slow--to approximately 2% with a 5% nominal GDP target. If output is at potential and the unemployment rate is at the natural unemployment rate, then there will be little increase in production or employment. That any increase would be small is just fine, it is rather whatever small increases that occur are undesirable. Sadly, in this situation, the increase in inflation would be greater. While that is unfortunately, it is the least bad result. When potential output is low or growing more slowly, the least bad alternative is for output prices to rise more rapidly rather than have nominal incomes (including wages) grow more slowly.

Tuesday, December 11, 2012

With a constrained, private central bank, the creation of money has nothing to do with public finance but rather with the profits earned by the owners of the central bank. Allowing a higher inflation rate allows the owners of the central bank to profit more by increasing the benefit of borrowing by issuing currency at a zero nominal interest rate. In other words, there are more profits from borrowing by issuing currency at a more negative real interest rate.

Suppose instead that ownership of the central bank is tied to operating a commercial bank. The Federal Reserve banks are jointly-owned by the member banks--commercial banks in their district. In the U.S., these banks earn only a token share of the profit generated by the Federal Reserve system. They receive a 6 percent annual dividend on the shares of stock they own. But suppose the Fed paid out all of its profits as dividends to the member banks?

At first pass, the most obvious effect would be to provide a powerful incentive for nonmember banks to join the Federal Reserve system. With the current rules, where stock ownership is 3 percent of capital and shares are issued or retired by the Federal Reserve banks at a price of $100, there would also be an incentive for banks to raise capital. Unfortunately, one can imagine sham banks being formed as a mechanism for capturing a share of the profits of the Fed.

On the other hand, it would seem relatively simple to change the rules so that stock ownership in the Fed was tied to total assets or perhaps something more closely tied to the banking business, such as commercial lending. As a monetary economist, the most obvious candidate for such a rule would be checkable deposits. Banks are special because they borrow by issuing deposits that can be used as money.

At least at first pass, if the profit from borrowing by issuing zero-interest hand-to-hand currency is distributed to banks in proportion to their issue of checkable deposits, then banks will compete away those profits by paying higher interest rates on checkable deposits. Such a rule would lead banks to fund more of their assets using checkable deposit. Further, it would seem to result in more finance passing through the banks--more intermediation--rather than direct finance.

Most interestingly, increasing the interest rate on checkable deposits would lower the currency deposit ratio. The typical household or firm would hold and use less currency for payments and instead use checkable deposits. This shift in the currency deposit ratio would not impact the total earning assets of the banking system--both the central bank and the commercial banks together, but rather only which institution holds the assets. The central bank lends less and the commercial banks lend more.

As before, this is not an unconstrained system. While it would be possible to have the central bank's currency redeemable in gold, silver, or foreign exchange, it would also be possible to require it to limit issue so to keep inflation on target. By increasing that constraint--raising the inflation target-- the central bank would benefit more from issuing currency, adding to its profit, which it would pass on to the member bank owners, and competition among those banks would raise the interest rates on deposits. This would be beyond the increase in the nominal interest rate paid on deposits due to the higher nominal earnings on loans due to the Fisher effect. The real interest rate on checkable deposits would rise as well as the nominal interest rate.

For those holding the liabilities of the banking system as a whole--the central bank and the member bank--a higher inflation rate implies a lower real interest rate on currency and a higher real interest rate on deposits. The total real demand for holding the liabilities of the banking system would be little affected, as would the total amount of assets held by the entire banking system, again, including both the central bank and the member banks. Shifting from a system where the profits of the central bank are paid out to member banks and competed away through higher deposit interest rates as compared to one where the owner of the central bank (perhaps even the government) keeps the profit, would increase total bank assets and liabilities. But the shifts in the constraining inflation rate would have little net effect on the total assets or liabilities of the banking system.

Suppose that the central bank makes an error, and expands the quantity of money more rapidly than is consistent with its target for inflation. The thought experiment is not a change in the target inflation rate as before, but rather a mistaken excess supply of money.

Assuming expectations regarding inflation are unchanged, (as they should be,) and given that all money creation is matched by increased lending by some part of the banking system--either the central bank itself or one of the member banks--the result would be a decrease in both real and nominal interest rates. For the most part, this is not beneficial to the banking system. At least if the banking system is perfectly competitive, the lower interest rates reduces its earnings, but with all banks earning less, they also lower interest rates on deposits. With zero nominal interest currency, there would be no decrease in the interest rate paid, but given the monetary regime where those benefits are transferred to banks in proportion to their deposits, the interest rates on deposits fall enough to reflect all of the reduced earnings.

Not only do bank depositors, as creditors earn less due to the lower interest rates, the resulting shift of bank depositors to investments in other securities would tend to drive down the returns to creditors who had been investing in those securities. With banks charging less on their loans, firms using direct finance, for example, selling commercial paper or corporate bonds to nonbank investors, also receive a benefit of lower rates. The increase in the supply of funds to direct finance and decrease in the demand for funds for direct finance, results in lower nominal and real interest rates.

The "Austrian" theory would be that the lower market interest rates impact the composition of demand. Those goods with demands that are relatively more interest elastic gain relatively more demand than those goods with demands that are relatively less interest elastic.

However, consider a business that finances its activity by selling commercial paper or corporate bonds to nonbank investors. They, like every other debtor, benefit and expand their borrowing. Some of the "old money" is shifted by bank depositors to direct finance, and some of the firms that were funding activities by selling commercial paper or bonds switch to banks. But those who had been involved in direct finance always are impacted in exactly the same way as those receiving "new money" from the banking system.

That this monetary regime implies that an excess supply of money impacts credit markets is important, but trying to identify which money is "new" is pointless. Not only is non bank finance impacted in the exact same manner, there is no point in trying to identify which client of the banking system received the added money. If the central bank purchases a newly issued bond (private or public) with the additional money, the reduction in the interest rate paid is no different than all the other borrowers who also borrow "old money" from the banking system. Similarly, the lower interest return obtained by the investor who would have purchased the bond that the central bank grabbed by spending the "new" money is no different from the lower interest return obtained by all of those holding "old" deposits in the banks or those investors using their "old money" to purchase newly-issued commercial paper or corporate bonds.

Further, the change in the pattern of demands depends on the interest elasticity of demand for various goods. Those who make extensive purchases of some good because of the lower interest rates don't necessarily borrow the "new" money. Those borrowing the "new" money might happen to purchase something whose demand is very interest inelastic. They would have made that purchase even if interest rates had fallen very little. In the limit, they would have made that purchase anyway with no reduction in interest rates or even higher interest rates. It could be some other household or firm, borrowing and spending "old money," or perhaps, not even borrowing at all but instead lending less because of the lower interest rates, that expands expenditure more than others.

Further, the benefit of the lower interest rates received by all borrowers is not due to spending money before prices rise. In this scenario, the central bank must reverse its error. Even if prices never rise, the lower interest rates due to the excess supply of money benefits all debtors and injures all creditors. If the government had a national debt, then it would benefit from the excess supply of money, like all debtors. And that would be true even if the central bank never held any government bonds!

Identifying the "Cantillon" effects of money with public finance depends on realistic institutional assumptions. With privatized arrangements, there is no impact on public finance. Still, focusing on who gets the new money first and emphasizing the notion that those receiving the new money first spend it before prices rise is wrongheaded.

Monday, December 10, 2012

Scott Sumner and Nick Rowe have both identified so-called Cantillon effects of money creation with "fiscal policy." Years ago, Martin Bailey discussed the basics of the inflation tax in 1956, and Dick Wagner at least partly identified the Austrian-type Cantillon effects with seigniorage revenue in a 1980 article.

I think that this approach is very realistic in the context of today's monetary regimes. The typical government runs budget deficits, monopolizes the issue of currency, and appropriates nearly all of the financial benefit from issuing currency. The rate of inflation impacts how much revenue is generated by the currency, and how that impacts other methods of raising revenue, taxation and borrowing with interest bearding debt, or total government spending or else one type of spending or other, involve public finance. My favorite thought experiment of newly-created money earmarked to one type of government purchase--tanks--is a bit artificial.

Much Austrian discussion of the matter, for example, Steve Horwitz's here, is highly abstract. The new money enters the economy in some specific place--not, the government issues new money and spends it on government programs.

Suppose issue of hand-to-hand currency is monopolized by a central bank, but the central bank is entirely independent of the government. Further, suppose the conspiracy theorists are right, and under this institutional framework, the profits earned by the central bank are paid out as dividends to the stockholders.

If this monopoly were entirely unconstrained, then presumably it could just print up currency and pay it out to the stockholders. The framing of government as counterfeiter could be applied. But instead suppose that the central bank is constrained. Not by some limit on the quantity of currency that it can issue, but rather a requirement that the currency maintain its value. This could be enforced by gold, silver, or some foreign currency. However, consider the scenario where the central bank is required to keep inflation on target.

With some redeemability contract, it is clear that the currency issued by the central bank is a form of debt. The central bank can issue all it wants, but it must stand ready to pay it off on demand. The monopoly privilege of the central bank is to be able to borrow at a zero nominal interest rate. It actually makes money from this by lending at a positive interest rate. (At the zero nominal bound, there is no benefit from issuing the currency.)

In my view, the inflation constraint is really no different than the redeemability constraint. If the inflation constraint can be enforced, say by shifting the franchise for issuing currency to another bank, then the central bank is benefiting from borrowing at a zero nominal interest rate and lending at positive interest rates.

Based on the Fischer relationship, the real interest rate at which the central bank can borrow by issuing currency is the negative of the inflation rate. It lends, let us suppose, at the real interest rate. It's profit margin is then the real interest rate plus the inflation rate. Of course, the same analysis can be made in nominal terms. It borrows at zero and lends at the nominal interest rate, and so its profit margin is the real interest rate plus the inflation rate, the nominal interest rate. Since the real demand to hold currency is negatively related to the nominal interest rate, it would be simple to calculate the profit maximizing inflation rate. However, there is no reason why the inflation rate imposed on the central bank as a constraint would maximize its profit. An inflation rate of 2%, 0%, or even some mild deflation that greatly limits the profit from issuing currency would be possible.

The point of outlining this alternative monetary regime is to point out that monetary policy would have no connection with public finance. A higher inflation rate would result in more real income for the owners of the central bank. A lower inflation rate would result in less real income for the owners of the central bank.

Perhaps those who sell luxury items to people owning stock in the central bank would benefit as well. But this has nothing to do with public finance.

I would also note, however, that the stockholders of the central bank are not getting the new money first, and they profit from the inflationary policy even though prices mostly like rise before they spend their dividend payments. Borrowing at a zero nominal interest rate is beneficial even if prices remain at their equilibrium values--even if there is no excess supply of money.